What is Going on in the Stock Market?

It is not always easy to be in the market when there seems to be a disconnect between fundamentals and reality, but this is where you make the most if you know how to buy and hold until the market fully reflects its real value.

There seems to be no clear signs yet of a strong market breakout as share prices continue to trend sideways despite improving economic outlook.

Interest rates as represented by the 10-year Philippine bond yield have already fallen to 5.03 percent from 7 percent at the start of the year, while inflation slowed down to 2.7 percent.

The release of first quarter earnings report by PSE Index stocks also showed relatively encouraging results at an average year-on-year growth of 9 percent, the strongest in the last three years.

But investors, particularly institutional funds from abroad, have yet to come into the market in a big way.

Meanwhile, the gap of the market’s earnings yield, which is the reverse of the current PE ratio at 15.6 times over the 10-year Philippine bond yield, continued to widen to 1.37 percent from 0.8 percent three months ago.

The rising disparity between these two yields obviously makes investing in the stock market very attractive.

Falling interest rates are supposed to increase stock prices because the opportunity cost is lower. Lower cost leads to lower risk, which increases a stock’s valuation.

But why is it that the market is still hesitant to move?

Current global uncertainties on rising trade tensions between China and the United States may be holding off funds from flowing into the local stock market.

The potential risk of this ongoing conflict may be extensive that can possibly slow down economies worldwide.

So, because of this emerging threat, while interest rates may be falling, the market risk premium is increasing.

If we assume the long-term earnings growth equal to GDP growth of 6 percent and add this to the prevailing earnings yield of the market at 6.4 percent, we can derive the market’s rate of return at 12.4 percent.

By deducting the current interest rate of 5.03 percent from the market’s required return, we can get the implied risk premium of 7.4 percent, which has risen significantly from 5.8 percent at the beginning of the year.

The increase in risk premium simply means that despite lower risk from declining interest rates, the market requires a higher excess return to compensate for the external uncertainties.

Such hesitation also seems to make the market less optimistic with growth expectations.

For example, almost a year ago, when the market was falling due to high interest rate at 6.8 percent, the value of growth incorporated into share prices of PSE Index stocks was 48 percent.

But today, with interest rate down to a low of 5.03 percent, the value of growth opportunities in stocks accounts for only 32 percent.

This is unusual because normally when interest rate is low, and the risk premium is high, investors will demand for higher share prices, which lead to bigger growth expectations.

Perhaps, it may just be a matter of time before things begin to clear up.

In the meantime, the current market situation presents a great opportunity to accumulate stocks that may have been potentially undervalued by the market based on growth opportunities.

It is not always easy to be in the market when there seems to be a disconnect between fundamentals and reality, but this is where you make the most if you know how to buy and hold until the market fully reflects its real value.

Henry Ong is a Registered Financial Planner of RFP Philippines. He is one of best selling book co-author of Money Matters. He also writes regularly as columnist for the Philippine Daily Inquirer.